Question

In: Finance

You have always been told that the cost of capital for Clark Upholstery is 9%, so...

You have always been told that the cost of capital for Clark Upholstery is 9%, so you started to evaluate the two alternatives (renew or replace) using the 9% cost of capital. However, it occurred to you that you have never calculated the cost of capital and you are not sure the last time some else may have calculated the cost of capital. Therefore, before you go any further in the process of evaluating the two alternatives you decide to calculate the cost of capital using the firm’s current capital structure and current yields on long term debt and equity. To make the calculation you know you need the balance sheet to determine the capital structure. Clark Upholstery’s current balance sheet is as follows:

Current Assets $75,000 Current Liabilities $25,000

Fixed Assets Long Term Debt (12%) $150,000

Land $100,000 Equity

Equipment 150,000 Common Stock $50,000

Total Fixed Assets $250,000 Retained Earnings 100,000

Total Equity $150,000

Total Assets $325,000 Total Liab & Equity $325,000

You will use the balance sheet to determine the relative weight of debt vs equity in your long-term capital structure. You also know that you must determine the current yield/value on your debt and equity in order to determine the after-tax cost of both debt and equity. Having both the relative weights of your capital structure and after-tax rates you can then determine your Weighted Average Cost of Capital (WACC), which you will use to evaluate the two alternatives (renew vs replace).

Your outstanding long-term bonds have a 12% coupon rate, but are selling at a discount on the publicly traded market. The current price is $88, that is $880 for a $1,000 face value bond. You need to determine the current yield/value of the current long-term debt. You are considering selling more bonds in the public market to finance the cost of the renewal or replacement. If you do this your investment banker is telling you that a 20-year bond would need a coupon rate of 13.6%, and to be sold Clark Upholstery would incur a $45 per bond discount and flotation costs of $32 per bond. Using this information, you calculate the cost of your current long-term bonds and also the cost if you sell $100,000 additional long-term bonds to finance the investment.

The other portion of your capital structure is your equity, which is comprised of Common Stock and Retained Earnings. Your stock is not publicly traded, so you decide to use the Capital Asset Pricing Model

(CAPM) to determine the cost of equity. To calculate the CAPM you need risk free rate (which you determine to be 4%) and also the markets expected return for the stock of companies like Clark (15%). Using historical information about Clark and also about the furniture Upholstery industry you determine that the firm’s beta is 0.88. You use this information to determine the equity cost of both Common Stock and Retained earnings.

Finally, you combine the debt and equity cost with the weights of debt and equity to determine Weighted Average Cost of Capital (WACC) assuming that Clark will finance the investment using the current mix of debt and use retained earnings (so no new equity is sold). You will also calculate the WACC assuming that Clark will finance $100,000 of the investment by issuing new bonds. Your Investment Banker advises you that taking on $100,000 of new long-term bonds will increase your Beta from 0.88 to 1.1.

You now have two WACC, one for the current capital structure and one that assumes the investment is financed by $100,000 of new long-term bonds and the balance being funded by Retained Earnings. You will use both WACC to evaluate the two investment alternative (renew or replace).

Now that you have all the calculations of incremental after-tax cash flow and WACC you are ready to evaluate the alternatives. To do this you decide to calculate all the classic evaluation methods, Payback Period, PV and its related Profitability Index and Internal Rate of Return. You have also heard about Modified Internal Rate of Return (MIRR) and aren’t sure if you will need/use it, but you will calculate it just in case. The company is concerned about an economic downturn in the near future which could throw off the revenue projections, and therefore has established a 4-year payback period as a pre-qualification for any new investments. You will now complete your project evaluation and do an accept/reject determination and a ranking for the two alternatives at both WACC.

Alt 1 Alt 2

26300   50100
36000   65200
35980   39420
43460   16340
33460   15940
1800   2200

Solutions

Expert Solution

Note: Number of years to maturity of current long term bond is not given, It is assmed to be 20years
Tax Rate is not given ,it is assumed to be 35%
Current Debt
Face value of each Bond $1,000
Coupon Rate 12.00%
Pmt Annual Coupon payment $120.00
Nper Number of payments 20 (Assumed)
Pv Current marke Value of each Bond $880.00
Fv Amount to paid at maturity $1,000
RATE Annual Yield To Maturity(Using RATE function of excel with Nper=20,Pmt=120,Pv=-880,Fv=1000)(Excel command: RATE(20,120,-880,1000) 13.79%
Before tax cost of Bond 13.79%
Cb After Tax Cost of Bond =13.79*(1-Tax Rate)=13.79*(1-0.35)= 8.96%
EQUITY:
CAPM EQUATION:
Rs=Rf+Beta*(Rm-Rf),Rs=Required return=Cost of Equity
Rf=riskfree rate=4%, Rm= Expected Market Return=15%, Beta=0.88
Rs=4+0.88*(15-4)= 13.68%
Ce Cost of Equity =13.68%
MARKET VALUE
Book value of Bond =325000-150000 $175,000
A Market value of bond=175000*0.88 $154,000
B Market Value of Equity=(Assumed to be equal to book Value) $150,000
D Total Market value of capital $304,000
Wb=A/D Wb=Weight of Bond in the total capital            0.51
We=B/D We=Weight of Common Shares in the total capital            0.49
After Tax Weighted average Cost of Capital:
WACC=Wb*Cb+We*Ce=0.51*8.96+0.49*13.68= 11.29%
If $100000 new Bond is issued:
Cost of New Bond:
Pv Discounted Price per Bond=1000-45 $955.00
Pmt Annual Coupon payment=1000*13.6% $136
Nper Number of years 20
Fv Payment at maturity $1,000
RATE Annual Yield To Maturity(Using RATE function of excel with Nper=20,Pmt=136,Pv=-955,Fv=1000)(Excel command: RATE(20,136,-955,1000) 14.29%
Before tax cost of new bond=142.9/((1000-32) 14.76%
Cn After tax cost of new Bond =14.76*(1-Tax rate)=14.76*(1-0.35) 9.60%
New Cost of Equity:
New Beta=1.1
We Cost of Equity =4+1.1*(15-4)= 16.10%
A Market value of old Bond $154,000
B Market value of new Bond=955*100 $95,500
C Market value of Equity= $150,000
D Total market Value of capital $399,500
Wb Weight of old bond                 0.39
Wn Weight of New bond                 0.24
We Weight of equity                 0.38
WACC=Wb*Cb+Wn*Cn+We*Ce=0.39*8.96+0.24*9.6+0.38*16.1= 11.92%


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